The Most Trustworthy Trust Bank

July 9, 2014

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Evercore

We expect another quarter of across-the-board misses for the trust banks based on a very challenging macro backdrop.

While we see ongoing risk of negative estimate revisions, eventual upside from rising short rates and possible discussions of incremental expense actions (as with Bank of New York Mellon (ticker:
BK
) recently) could support the stocks. Our top pick remains State Street (
STT
) although plenty to consider for each with Northern Trust (
NTRS
) putting up better results recently and an activist shareholder recently disclosing a stake in Bank of New York.

We are reducing our estimates slightly for Northern Trust and State Street based on even worse exchange-rate volatility since our midquarter run. For Bank of New York we are raising our estimates modestly as worse exchange-rate volatility is more than offset by an incremental $100 million in cost saves announced during the quarter.

We are about 3%-4% below the consensus estimate for second-quarter earnings per share for each trust bank. With that in mind we again find it challenging to distinguish which has the best setup into the quarter. Bank of New York has outperformed and screens expensive on a relative basis, but recent expense actions could support estimates and recently disclosed stake by activist investor could support sentiment. Northern Trust remains the most expensive, but intermediate-term (2014/2015) EPS growth should outpace peers given a declining pace of non-comp expense growth and stabilizing net interest margins (NIM)/spread. State Street shares remain most attractive on a relative basis; however, we believe EPS growth is likely to lag peers in the intermediate term, and we see the greatest risk of downward estimate revisions in fiscal 2015/2016.

While seasonal declines in equity compensation should result in positive operating leverage on a last-quarter basis (most pronounced for State Street), negative year-over-year operating leverage is likely based on top-line weakness and now little margin for error in achieving on a fiscal-year basis. As such, we would not be surprised if there was a push for additional expense actions (as announced by Bank of New York recently).

While State Street has been most proactive on the expense front targeting savings of 10% of its original cost base with its information-technology/operations program (versus peers at about 6%) along with several one-off headcount reductions since, we now model negative operating leverage of about 100 basis points in fiscal 2014 (based on its operating definition) and estimate management would need to cut another $80 million in second-half 2014 to turn positive.

Activism is likely a key factor for Bank of New York now, but less opportunity than with State Street two-plus years ago, Bank of New York management is clear that they are unlikely to spin asset management, and a greater case to unlock value at the universal/money-center banks.

Trust banks have outperformed Standard & Poor's financials since first-quarter earnings in spite of the mixed macro backdrop and negative estimate revisions. As a group trust banks trade at 15.6 times forward consensus or a 17% premium to the S&P financials index (versus historical 15.3 times or a 21% premium, respectively). We continue to view the group as attractive longer term given potential for sustainable double-digit EPS growth and good optionality

-- Andrew Marquardt -- Doug Johnson

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